Taking Cues From the Public Sector

The modern corporation can be traced back four centuries to the formation of the Dutch East India Company, considered the first joint-stock company. On the other hand, democracy has been employed in different parts of the world for millennia. It stands to reason, then, that corporate governance could learn a trick or two from public-sector governance.

That’s the point that is made by Matthias Benz and Bruno S. Frey, assistant professor and professor, respectively, at the Institute for Empirical Research at the Economics of the University of Zurich. In a paper to be published in the January 2007 issue of Academy of Management Review, “Corporate Governance: What Can We Learn From Public Governance?” Benz and Frey contrast four areas of public- and private-sector governance: compensation, division of power, succession and competitive elections.

Politicians typically receive fixed salaries, as opposed to the incentive-laden contracts of most CEOs, ostensibly to ensure that elected officials don’t set policy that they could easily manipulate for their own monetary benefit. But the opposite is true in the private sector, in particular when it comes to equity-based compensation. Having “skin in the game” is supposed to align executives’ interests with investors’ because of the sense of ownership that stockholding endows. But when the vast majority of a CEO’s compensation comes in the form of equity such as stock options, incentives can arise for an executive to manipulate the stock price, and opportunity is plentiful.

To be clear, Benz and Frey recognize that CEOs deserve to be well paid. However, they suggest that a more equitable balance of market-set salary and reasonable equity would reduce perverse incentives.

Another lesson could come from the concept of division of power between managers and shareholders, as represented by boards of directors. In theory, this structure should resemble the checks and balances among branches of government, which operate within parameters that enable each branch to oversee the others.

In practice, of course, CEOs have long dominated the board-room. Even if directors have stepped up their governance in recent years, institutional norms still stack the deck in favor of CEOs. For example, CEOs often dominate the nominating committees that select future directors and usually (in the United States) hold the title of chairman. While these norms may not predict malfeasance, they tend to undercut the concept of checks and balances. Thus, it might make sense, for example, to uncouple the CEO and chairman positions and more easily afford a board the ability to check executive power.

Then there’s the issue of succession among CEOs and directors. In the public sector, set term lengths, say of four or six years, are common. Similar term lengths could have positive effects for corporate chiefs. For example, the guarantee of a term in office bestowed upon a newly elected leader could reduce the quarterly pressures exerted by the stock market, at least at the start of the term. It’s certainly true that election cycles can also lead politicians to pander for votes as elections come near —and the same could be true of incumbent CEOs running for re-election. But for a period of time, the leader can take a longer-term perspective. Term limits for CEOs or directors could also be used. The idea is to limit the accumulation of power among incumbents and to ensure the periodic infusion of new and fresh ideas.

As it is, shareholders have to trust that the right directors are in place. Benz and Frey point out that while competitive elections are a bedrock of democratic public-sector governance, competition is very rare in elections for directors. Why not ask the nominating committee to come up with extra candidates and let shareholders decide?

Both authors stress that the paper is not meant as a manifesto for new laws. What the authors really intend is to provide food for thought for policy-makers, managers, directors and shareholders. Many of their suggestions, they feel, should be publicly debated and considered as options by investors on a company-by-company basis. Even if a practice were adopted as law, such as term limits of eight years for directors, shareholders might be given the choice of opting out, Benz says. In this way, the market would decide over time which practices are appropriate for each company.

The authors also recognize that public-sector institutions are not immune to scandals and poor governance. But certain structures and norms have proven resilient and effective enough over many years in many cultures to outweigh their disadvantages. It could be time for private companies to learn from them.

The paper is currently available for download at http://papers.ssrn.com/sol3/pa-pers.cfm?abstract_id=894821. For more information, contact Matthias Benz (mat-benz@iew.unizh.ch) or Bruno S. Frey (bsfrey@iew.unizh.ch).